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SEC's Amazon.com Inquiry Could Get Much Uglier

Lehman analysts raise two additional concerns.
Craig Schneider, CFO.com | US
October 30, 2000

Amazon.com's stock has been sinking faster than the price tags on Christmas ornaments after Dec. 25 ever since the e-tailer warned in a regulatory filing that the Securities and Exchange Commission has launched an informal inquiry into Amazon's accounting practices.

However, even as investors fret about the SEC's probe, two Lehman analysts are concerned about additional Amazon accounting practices.

Amazon.com disclosed last Tuesday that it has received and responded to the SEC's questions on the "accounting treatment and disclosures for some of its initial Amazon Commerce Network transactions," which are promotional partnerships with other retailers. That much we know already.

Partners would pay Amazon.com an equity stake in lieu of cash for a service, such as prominence on its homepage. Amazon would then recognize the ACN stock as revenues, split over each quarter for the length of the contract. The SEC makes sure those values are not being overestimated.

Not surprisingly, Amazon.com's CFO Warren Jenson publicly expressed confidence that the company's accounting and disclosures have been correct and "appropriately conservative."

But regardless of what may come of the SEC's informal inquiry of this matter, Amazon.com has other accounting issues that could, if it hasn't already, peak the SEC's interest.

Questions about Amazon's presentation of fulfillment costs, for expenses such as shipping books and CDs.
According to Robert Willens, Lehman's tax and accounting analyst, Amazon has been treating fulfillment costs as marketing expenses, or SG&A, as opposed to cost of goods sold.

However, Willens explains to CFO.com that the SEC prefers fulfillment costs to be part of the gross margin. "So I don't think there's any doubt to the outcome of this one," he adds.

Obviously, the bottom line is unaffected whether fulfillment costs are deemed to be "marketing costs" or "costs of goods sold." So, why is this accounting treatment such a big deal?

Because, for retailers, the gross margin is the key industry-wide barometer for measuring profitability and therefore comparing one retailer from another. So, a company that is not allocating the same kinds of expenses its competitors are using to calculate the gross margins is misleading shareholders and its competitors.

What would happen if Amazon were forced to restate its gross profits? "I do believe that it would be a very large restatement and it would cause the gross profit margin to plummet to almost nothing, if not less than zero with costs exceeding revenue," insists Willens.

Patricia Smith, an Amazon spokeswoman, responds: "That matter has been resolved. FASB made recommendations consistent with how Amazon was classifying its fulfillment costs."

She's right. FASB made a ruling…but sort of. "The task force decided not to specify income statement presentation, but they required disclosure if shipping and handling costs are not included in costs of sales," says Carlo Pippolo, practice fellow at FASB's emerging issues task force.

More importantly, the FASB decision has left the door wide open for the SEC to make changes to fulfillment costs, Willens argues. "It doesn't mean that the SEC won't enforce it in terms of its own guidelines," he says. "It means that FASB has left it to the SEC, and the SEC is certainly interested in this issue."

Willens adds that SEC inquiries can go on for six months. If it then requires Amazon to change its fulfillment cost presentation, this could have industry-wide accounting implications.

Amazon's cash accounting could also complicate the SEC's current inquiry.

Amazon's classification of cash and marketable securities is another issue that could attract SEC attention.

In a report last Thursday, Lehman bond analyst Ravi Suria cited a footnote on Amazon's press release that reclassifies its equity investments in Webvan and Sotheby's as cash and marketable securities, raising the total for that line item by $96 million to $900 million.

"Just like the company is facing SEC investigation into the recognition of ACN stock as revenues," Suria wrote, "it could potentially face problems with portraying stock as a cash equivalent — especially if it is now 12% of the so called 'overall cash' number."

How crucial is this issue? Suria figures if you exclude the stock additions and a one-time gain of about $75 million, Amazon.com is left with an "operating" cash balance of only about $730 million, which the analyst adds: "significantly increases our worries about the balance sheet."

Lehman's Willens, whose comments are paraphrased in Suria's note, takes the alleged cash distortion issue a step further: "It is usually inappropriate to portray anything in the available for sale account as a marketable security that can be construed as a cash equivalent."

So excluding the marketable securities line, Amazon.com had $647 million in cash left at the end of the third quarter, in sharp contrast with the $900 million recorded as cash and cash equivalents.

The case of the "missing cash."
What's more, Suria is still wondering where $173 million in cash went.

He's referring to 1) the $96 million from classifying stock as cash/marketable securities, 2) the $20 million it generated from the sale of inventory to Toys "R" Us and 3) the $57 million that it received from ACN partners that has not yet been recognized as revenue.


"As the money did not go into investing or financing, it quite possibly went into operations — which means that the negative operating cash flow was possibly $173 million greater than the $4 million that the company reported," Suria notes.

"Given that in our opinion, the cash number (which is usually the most inviolate of the numbers on the income statement, balance sheet or cash flow statement) does not fully represent 'cold hard cash,' we look forward to the filing of the 10-Q."

Click here for a copy of Amazon.com's 10-Q, just released today.




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